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Tuesday, October 04, 2005

Market Imperfections

This post started out as a response to a comment, but after I'd written several paragraphs, I realized it should stand on its own. A reader indicated some concern about a statement I made in yesterday's posting, relating to government incentives for promoting greater energy efficiency. He responded, "There's a Libertarian hiding in my Republican body who cannot accept managed economics." I can appreciate that sentiment. However, I think we have to draw a distinction between managing markets and managing economics. After all, more than half our laws and tax policies, whether introduced by Republican administrations or lawmakers or Democratic ones, are aimed squarely at the latter.

You can't spend 10 years trading commodities without becoming a believer in the power of markets. But you also get a sense for their limitations, for when and where markets don't work well enough or with enough foresight. That's not socialism; it's pragmatism. Now, I think there's tremendous scope for applying market solutions to problems that would have previously been attacked with purely policy measures. Greenhouse gas emissions trading is a great example of that. But without some kind of policy fix, be it higher fuel taxes, stronger CAFE standards, or incentives for efficiency investments, the US energy market will simply deliver more SUVs, higher consumption, and higher imports.

That, after all, is the world we've lived in for the last 25 years, since Reagan deregulated energy prices. Free markets did a great job of bringing down oil prices in the 1980s, and creating a much more diverse base of supply for our growing oil imports. But markets can't insulate us from the consequences of a global supply shortfall, or a localized weather catastrophe, any more than they can pre-price (or preempt) the effects of a truly discontinuous event, such as a peak in global oil production or a permanent gap between actual supply and theoretical demand. There are just some areas in which markets need a bit of a nudge from time to time; that's a classic role of government, going back to the Founders.

Having said that, I've also written about the importance of those nudges focusing on the results we want, and not on the means to achieve them. That means providing incentives for better fuel economy, not for hybrid cars (or some other specific technology.) I don't see this as a replay of the 1980s debate over industrial policy, focused on picking winners or losers. Rather, it's a question of embedding a bias for efficiency into our economy--not at the expense of everything else, but more than our short-term-focused markets would provide. There are a lot of us who think that this will pay financial and geopolitical dividends in the long run, too.